By Greggory Warren, CFA | Senior Stock Analyst
One of the primary goals of our Ultimate Stock-Pickers' concept is to come up with investment ideas that not only reflect the most recent buying and selling activity of top investment managers, but are timely enough for investors to get some value from them. By cross-checking the most current valuation work and opinions of Morningstar's own stock analysts against the actions of some of the best equity managers in the business, we hope to uncover ideas that investors will find useful. With more than two thirds of our Ultimate Stock-Pickers having already reported their third-quarter holdings, we've scoured through the trading activity of these top managers to get an early read on how some of them have been putting money to work.
Looking at the purchases that our Ultimate Stock-Pickers make in any given period, we tend to hone in on both high-conviction purchases and new-money buys. We believe that managers send signals about the level of conviction they have in a position by how much of their portfolio (on a percentage basis) they're willing to commit to a given name at any point in time. For example, we can generally assume that the managers at FMI Large Cap (FMIHX), which had 5.8% of its stock portfolio invested in 3M Company (MMM) at the end of the September quarter, compared to just 2.3% in Willis Group Holdings (WSH), have a higher degree of conviction in 3M than they do in Willis Group. That said, position size can sometimes be influenced by how much a portfolio manager wants to commit to a particular sector (especially when there are only a few truly investable ideas in that sector). It can also be influenced by large legacy positions that have become difficult to unwind.
We define high-conviction purchases as instances where managers make meaningful additions to their existing holdings, or make significant new-money purchases in names that were not in their portfolio at the end of the previous quarter, with a focus on the impact these transactions have on the overall portfolio. We believe that new-money purchases provide us with the most insight into what our top managers think are the most attractive buying opportunities, as portfolio managers tend to only put money to work in new names when their purchase decision carries a very high degree of conviction. This is based on the belief that it is far easier for investment managers to put money to work in holdings that they are already comfortable with than it is for them to make a bet on a name that would represent a new addition to the portfolio.
When looking at all of these different stock purchases, though, it pays to remember that the decision to buy these securities was made during a prior period. This means that the prices our top managers paid will likely be different from today's trading levels. As such, a stock that had our managers excited in the latest period might end up being less (or more) attractive, depending on the direction that the markets or the news flow for a particular firm has taken. With the S&P 500 trading in a range of 1,335 to 1,465 during the third quarter, and closing out last week at around 1,360, it is highly likely that some of the prices our managers paid during the most recent period were slightly higher than the prices investors are seeing today. This once again exemplifies our ongoing belief that it is extremely important for investors to assess the current attractiveness of any security they are considering by looking at some of the measures that our stock analysts' research regularly provides us with, like the Morningstar Rating for Stocks, and the price/fair value estimate ratio.
Top 10 High-Conviction Purchases made by Our Ultimate Stock-Pickers Star Rating Moat Size Current Price (USD) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) No. Funds Buying Rsrch-Mtn (RIMM) 2 None 9.20 1.31 Very High 4,972 2 Annaly Cap'l (NLY) N/A N/A 14.80 N/A N/A 15,018 1 Tronox (TROX) N/A N/A 15.69 N/A N/A 1,777 1 CncoPhllps (COP) 3 Narrow 55.03 1.06 Medium 67,339 1 CME Group (CME) 3 Wide 54.24 0.92 High 18,136 2 JPMorgan (JPM) 4 Narrow 39.53 0.78 High 150,804 1 Apple (AAPL) 5 Narrow 527.68 0.69 Medium 498,326 3 Accenture (ACN) 3 Narrow 66.19 0.97 Medium 46,117 1 CH Rbnsn (CHRW) CHRW 4 Wide 59.16 0.81 Medium 9,477 1 J&J (JNJ) 4 Wide 69.19 0.90 Low 192,077 1
Stock Price and Morningstar Rating data as of 11-16-12.
Not unlike the first quarter of this year (and the fourth quarter of last year), the third quarter was exemplified by a dearth of buying activity (in aggregate) by our Ultimate Stock-Pickers. The list of top 10 high-conviction purchases highlights this fact, as most of the securities purchased during the period had just one or two managers buying shares, compared to prior periods (like the second quarter) when it has taken as many as four managers buying a security to push a name up to the top of the list. This doesn't surprise us too much, given that global equity markets put in a solid showing during the third quarter, and the fact that investors continued to pull money out of actively managed U.S. and international stock funds during the period. This also helps to explain why we were seeing a bit more selling activity during the third quarter, exemplified by a lot of position-trimming and a few truly meaningful sales, as our managers were likely anticipating a downturn in the markets--given slowing growth in both developed and developing economies, the ongoing European debt crisis, and the upcoming U.S. elections and pending "fiscal cliff"--and were building up cash to meet redemption requests, as well as for future purchases (in a more reasonably priced market).
Looking over the list of top 10 high-conviction purchases we've seen so far from the most recent period, one name-- Apple (AAPL)--clearly stands out among the rest. This is not only because three of our top managers-- Alleghany (Y), Columbia Dividend Income (LBSAX) , and RS Capital Appreciation (RCAPX)--were making meaningful purchases in the name (with Columbia Dividend Income actually making a new-money purchases in the security), but because it is the only stock on the list that is still trading below the $539 per share Consider Buy price our analyst Brian Colello has attached to his fair value estimate. Apple may be the most valuable company (by market cap) that the world has ever seen, but Colello believes that there are still plenty of avenues for growth in the years ahead. He expects tremendous iPhone growth, not only as the smartphone market doubles between 2011 and 2014, but as the iPhone gains share as a result of the ongoing struggles at Nokia (NOK) and Research in Motion (RIMM). Colello feels that iPad revenue should also grow at an outstanding rate, as consumers continue to adopt tablets over, or in addition to, PCs, and the company generates additional sales with the launch of the iPad mini. He thinks that adoption of these devices will raise the switching costs associated with moving to alternative phones and tablets, and Apple's lock-in via iOS and iCloud could spur market share gains in Mac and potentially any future Apple TV products. With the company looking at a strong iPhone 5 launch into the holiday season, Colello feels that the current share price is not fully reflecting the value that Apple should be able to generate for shareholders in the near- to medium-term.
While not quite making the list of top 10 high-conviction purchases, it is interesting to note that one other company-- American International Group (AIG)--had three of our top managers-- Diamond Hill Large Cap (DHLAX), Hartford Capital Appreciation (ITHAX), and Oakmark (OAKMX)--making meaningful purchases in the name. As we had noted last quarter, up until this year, only Bruce Berkowitz at Fairholme (FAIRX), Saul Pannell at Hartford Capital Appreciation, and the managers at Mutual Shares (TESIX), were willing to commit capital to the firm, which has been mired in controversy ever since the U.S. government had to bail it out at the height of the financial crisis. With two other managers--Oakmark and FPA Crescent (FPACX)--making new-money purchases in the name during the second quarter, and Diamond Hill Large Cap joining them with a new-money purchase of their own during the third quarter, the number of Ultimate Stock-Pickers holding stakes in AIG has now risen to six. Of their purchase of shares in the insurer, the managers at Diamond Hill Large Cap--Chuck Bath, Bill Dierker, and Chris Welch--noted the following:
"We initiated a position in property and casualty insurer American International Group, Inc. at a meaningful discount to our estimate of intrinsic value. We believe the combination of an improving return on equity in the core insurance business and a reduction in non-core assets should lead to above average earnings and book value per share growth and subsequent improvement in market valuation."
Although this explanation was not quite as verbose at Bill Nygren's take on the company last quarter, it does arrive at a similar conclusion--the shares are not currently reflecting the true value of the business. While Morningstar analyst Jim Ryan agrees that the shares are materially undervalued when compared to his own valuation (which assumes nothing more than mediocre results over time), he feels that there is still some uncertainty surrounding the proceeds that AIG will ultimately realize from selling its non-core businesses (specifically the aircraft leasing business, and its interest in Pan-Asian insurer AIA). Although Ryan agrees that the company has made significant strides in its recovery, he feels that, from an economic moat perspective, AIG fails the test in almost all regards, believing that the road to re-establishing its competitive position will be long and extremely difficult. The firm's Chartis subsidiary has underperformed the property and casualty insurance industry where it competes, and AIG's life insurer, SunAmerica, operates in a commodity-like industry in which economic moats are almost impossible to establish. While the shares are undervalued at today's prices, he feels that the very high uncertainty that can result in volatile earnings over the near term should be considered before making an investment in AIG.
Top 10 New-Money Purchases made by Our Ultimate Stock-Pickers Star Rating Moat Size Current Price (USD) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) No. Funds Buying Annaly Cap'l (NLY) N/A N/A 14.80 N/A N/A 15,018 1 Tronox (TROX) N/A N/A 15.69 N/A N/A 1,777 1 Accenture (ACN) 3 Narrow 66.19 0.97 Medium 46,117 1 CH Rbnsn (CHRW) 4 Wide 59.16 0.81 Medium 9,477 1 Philip Morris (PM) 3 Wide 84.93 0.92 Medium 143,502 1 Analog Dvcs (ADI) 3 Narrow 39.33 0.89 Medium 11,738 1 UPS (UPS) 4 Wide 70.02 0.88 Medium 66,505 1 eBay (EBAY) 4 Wide 47.26 0.89 Medium 62,127 1 Cummins (CMI) 3 Narrow 95.78 1.01 High 18,379 2 Citigroup (C) 4 Narrow 34.98 0.76 Very High 101,910 1
Stock Price and Morningstar Rating data as of 11-16-12.
While there was a bit of overlap between our list of top 10 high-conviction purchases and those listed as top 10 new-money buys during the third quarter, with Annaly Capital Management (NLY), Tronox (TROX), Accenture (ACN), and CH Robinson Worldwide (CHRW) all falling into that category, there was only one company-- Cummins (CMI)--that saw more than one manager putting new money to work in the name. With relatively few bargains in the market during the third quarter, exemplified by the fact that stocks under Morningstar coverage were trading at around 90% of fair value on average during the period, we're not surprised by the lack of depth in the new-money purchases that occurred during the quarter. In fact, in order to find anything that our analysts would be recommending more heavily, we had to expand our list to twenty-five names before we found any stocks--Apple and WellPoint (WLP)--that were trading below their Consider Buy prices. And from a pure purchasing perspective, we are seeing a lot more buying activity from some of the insurance companies included on our list, with Alleghany and Berkshire Hathaway (BRK.A) /(BRK.B) standing out the most for the level of trading we've seen from these firms, which have traditionally been a bit more staid. For those that may have missed it, we talked in a bit more detail about the increased trading activity at Berkshire in our last article.
Looking more closely at Cummins, which was purchased by both Alleghany and Oakmark during the third quarter, the stock did dip as low as $82 per share during early July, but has since recovered, and is trading more in line with Morningstar analyst Basili Alukos's $95-per-share fair value estimate. In explaining his new-money purchase of Cummins to Oakmark's shareholders, Bill Nygren noted the following:
"Cummins is the world’s second-largest manufacturer of engines and the largest maker of truck engines. While North America is still its largest market, Cummins has been very successful in building sales and market share in faster-growth emerging markets, which now account for about a quarter of companywide sales. Further, we believe that its undisputed position as the industry leader in emissions controls technology should provide a long-lasting tailwind as countries mandate progressively tighter emissions standards in upcoming years. Cummins earned just over $9 per share last year, so it wasn’t surprising to see the stock reach a price of $130 in March. By July, however, as investors became increasingly concerned about the possibility of decreasing global growth, the stock hit a low of $82. We believe the decline was an overreaction. Cummins now sells at about 9x expected current-year earnings. Like many of our holdings, we expect Cummins to achieve mid-single-digit revenue growth over the economic cycle, and expect per-share growth to be higher as excess cash flow is devoted to share repurchase. Our expectation for above-average EPS growth, a moderate but growing dividend and a higher P/E multiple results in us believing Cummins is likely to produce above-average returns."
Some of which syncs up with our analyst's thinking on Cummins, with Alukos noting that the firm has historically capitalized on new emissions standards to steal market share from the competition, expecting Cummins to produce similar results in the coming decade as increased fuel economy standards and the international adoption of emissions controls drive growth for the industry overall. Alukos also notes that the firm diversified its business to become less cyclical by expanding its parts and service business and moving more heavily into emerging markets. Alukos continues to believe that Cummins, which basically reinvented itself during the previous decade, has emerged stronger than ever, and is uniquely positioned to capitalize on the tailwind that will be created by progressively tighter emissions standards around the globe. Based on long-run projections that include 13% EBIT margins, he believes that Cummins' average earnings power is somewhere between $9 and $10 per share. At this point, though, he'd prefer to see a far greater discount to his fair value estimate before recommending the shares.
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Disclosure: Greggory Warren does not own shares in any of the securities mentioned above. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.